An asset-backed security is a security that is backed by a pool of loans or receivables. These include: auto loans, consumer loans, commercial assets (planes, receivables), credit cards, home equity loans, and manufactured housing loans.
ABSs are essentially the same thing as a mortgage-backed security except that the security is backs assets such as loans, leases, credit card debt, a company's receivables, royalties, etc and not mortgage based securities.
Special Purpose Vehicles and Their Effect on Asset-backed Securities
SPVs are also referred to as a "bankruptcy-remote entity" whose operations are limited to the acquisition and financing of specific assets. The SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt.
Thanks to Enron, SPVs/SPEs are household words. These entities aren't all bad though. They were originally (and still are) used to isolate financial risk.
A corporation can use such a vehicle to finance a large project without putting the entire firm at risk. Problem is, due to accounting loopholes, these vehicles became a way for CFOs to hide debt. Essentially, it looks like the company doesn't have a liability when they really do. As we saw with the Enron bankruptcy, if things go wrong, the results can be devastating.
Why Issue Asset-Backed Securities?
The primary motive for issuing asset-backed securities is to take an asset, such as a receivable, a loan or some other form of illiquid asset, and move it off the balance sheet. This helps the parent to clean up its balance sheet and monetize those receivables rather than waiting for the payments to come in. It can also help protect those assets in case the parent defaults. This is possible because the SPV that was created is a separate entity.
Types of Credit Enhancements
Credit enhancement is designed to reduce risk. It comes in two forms:
- Internal Enhancements: Internal enhancements come in the form of reserve funds over collateralization and senior/subordinated structures. These will be covered in more detail in the CFA Level II exam.
- External Enhancements: External enhancements come in three forms of third-party guarantees. These include: corporate guarantee, letter of credit and bond insurance. The enhancement can come from the parent company or from the newly created company that holds the assets. One problem with external enhancements is that one not only has to analyze the assets and the company that owns them but also the company that is "wrapping" or insuring the debt.
Collateralized Debt Obligations
An investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds.
Similar in structure to a collateralized mortgage obligation (CMO) or collateralized bond obligation (CBO), CDOs are unique in that they represent different types of debt and credit risk. In the case of CDOs, these different types of debt are often referred to as 'tranches' or 'slices'. Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays.
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